Has recent market adjustment affected reform drivers involving China banks?

A- and H-share banks had changes.

Recently, it has been noted that A-share and H-share China banks had significant adjustments --A-share dropped by 9.0% and H-share declined by 4.9% after a rally of 42.8% and 16.7% in the past 6 months.

According to a research note from Barclays, the decline is likely a spill-over effect by the China Securities Depository and Clearing Corporation’s new repo rule that disqualifies some low-quality LGFV bonds to be used as collateral for borrowing and trading.

The intention of the new rule is to prevent risk from low-quality LGFV bonds but may have generated some tightening impact on liquidity, said the report.

The recent strong stock market performance has been supported by margin trading and is thus sensitive to liquidity changes.

In spite of the weak performance recently, Barclays believes that the key fundamental drivers, e.g. broad reforms, remain in place and some price adjustments are normal after a rapid rally.

Here's more from Barclays:

The China Securities Depository and Clearing Corporation Limited (CSDC) announced on 8 December 2014 that it will suspend the qualification review/approval of new enterprise bonds as collateral for bond repurchase transactions unless the issuer has a rating ≥ AA and the specific bond has a rating of AAA at the same time.

In addition, bonds that have obtained qualification previously but cannot meet rating requirements will not be allowed to be used as collateral for new repo transactions any more.

The CSDC explained that the purpose of this action is to prevent potential risk of spillover from bonds issued by local government financial vehicles (LGFVs).

As a major step toward local government reform, local governments have been required to submit to the Ministry of Finance how much debt they are responsible to pay back by 5 January 2015.

As local governments may not be responsible for some debts (including LGFV bonds), it is difficult for the CSDC to judge potential risk and impact on the bond market in the case of any bond default, the CSDC said in a follow-up statement on its website. We expect the new repo rule to have some tightening impact on liquidity.

During the second half of this year, the domestic stock market has performed strongly, with SHCOMP rallying by 47% from 1 July to 8 December, in comparison with HSCEI’s rise of 15%.

In our view, during such a rapid market rally, some price adjustments are normal, especially given the increased leverage caused by rapidly growing margin lending and liquidity impacts such as the repo rule change. Regarding China banks, however, we believe the fundamental drivers behind the rally, i.e., the broad reform theme and soft landing scenario post rate cut cycle, are still in place.

Currently, China banks’ valuation implies an undemanding average of 0.8x 2015E P/B ratio based on closing prices as of 9 Dec 2014. Our price targets suggest an average 10.5% upside potential on China banks under coverage, and an average 17.6% upside potential on those rated Overweight (BOC, BOCOM, CMB and CITIC Bank).